Toward a theory of responsible investing: On the economic foundations of corporate social responsibility

• We develop a model that links socially responsible investing and corporate social responsibility.
• Responsible firms have higher market-to-book ratios and higher return on assets.
• The overall effect on stock market returns depends on the relative strength of demand and supply side effects.
• Our framework reconciles the contradictory findings from the empirical literature.

Studies that link corporate social and financial performance usually find a positive association between the two. However, the literature does not establish a significant impact of socially responsible investing on stock market returns. We develop a coherent economic framework of responsible investing to address this paradox. The framework offers theoretical underpinnings for all research on responsible investment as it provides the theoretical underpinnings for the actual behavior of market participants. We associate corporate social performance with key financial accounting ratios like the market-to-book ratio (market value of the firm in relation to accounting value), return on assets, and stock market return. We conclude that there is a strong theoretical foundation for a positive relationship between corporate social responsibility and financial performance, though the relation is conditional on which financial performance measure is considered. We illustrate that the empirical literature about responsible investing is well in line with our model's propositions.